Audit Reform: A welcome sign of change for mid-tier firms

To the delight of many in mid-tier accounting circles, we are now beginning to see significant, wide-ranging steps being taken to reform audit practices in the UK. It is pleasing to see that after six years since the various reviews and recommendations we finally seem to have a commitment to reform.

It is absolutely necessary to ensure that corporate reporting in the UK is seen as strong. We want the UK to be seen as a safe investment for both UK based and overseas investment. This is especially important in the midst of the current levels of global political and economic volatility we are experiencing.

Financial services organisations need to trust the information they are presented with to ensure cash needs of their clients are met. If they cannot rely on audits, then they have to do more themselves, potentially pushing up the cost of capital.

This is important because, for instance, an investment manager can only take considered risk-based decisions on investments if the independent assessment from audit can be trusted. If there is less trust in the audit report, then the other costs of oversight, be it legal, insurance, investor relations or otherwise will increase and push

As the Financial Reporting Council’s (FRC) annual review of audit quality highlights, the gap between the Big Four and mid-tier audit quality is increasing. Not only is this a threat to the UK audit market and economy as a whole, but the growing divide poses a commercial threat to the ability of mid-sized firms to chip away at the Big Four market share.

The commitment to removing rules that are unnecessary for smaller public interest entities (PIES) is one important intervention. Regulators at the FRC have previously treated all PIE audits similarly whether they are the largest FTSE company or the smallest PIE company, often resulting in a competitive disadvantage for mid-tier audit firms.  As such, for many years, those firms, via the Association of Practising Accountants’ (APA), have been working with the FRC to promote the concept of proportionality and scalability of regulation.

Given the cost of entry to the PIE audit market and cost of regulatory compliance, coupled with the risk of serious penalties in the event of a no-fault client failure, the potential for reputational risk has largely been deemed as too great for mid-tier firms to really consider the PIE market. Hence a contraction in choice for PIE companies when it comes to auditors.

What’s more, many smaller PIEs, and those unlisted companies set to fall under the expanded definition of a PIE, may not have the complex control systems a FTSE 100 company does. This does not mean they are deficient, as long as the control environment is fit for purpose.

It is important to note that the changes will only be successful if the regulator also acts proportionately when reviewing auditors work across different size files. The regulation costs (financial and reputational) are a key barrier to auditors entering this market. Audit quality is a must, but this can be achieved within the framework of proportionality.

When looking at conflict rules it is similarly important to remember that auditors to owner managed (non-PIE) businesses do not get caught by the same onerous rules. These companies do not have the management time to have different advisors and they value the additional knowledge their auditors can bring to the table.

It is also encouraging to see the onus being placed more on directors. Too often the blame for corporate failure is laid at the door of auditors when in reality it is the actions of directors that are the root cause.

Part of this problem is that auditors are regulated and therefore have a process for dealing with failures. Broadly speaking, directors can often face limited consequences for their actions unless fraudulent activity is discovered, and even then, this can be hard to prove and prosecute.

As a result, auditors are often an easy target, though this is not to say that some in the profession should not have been criticised in recent history. Recent high-profile failures have rightly been brought to the fore; however, this can often create the misconception that such errors are commonplace. On the contrary, mid-tier firms perform a vital role in the non-PIE SME market, which often goes under the radar.

The various reforms proposed here, will hopefully enable mid-tier firms to take on more work and build on the work led by the APA in areas such as the FRC Scalebox initiative which seeks to help mid-tier firms scale up to meet the PIE demands, in other words fulfilling a training role and not just being a disciplinarian with a stick! The hope now is that all of this will help build trust in UK companies, avoid corporate failures and protect jobs. This said, there is a long road ahead and we await the detail to follow on the intricacies of the proposals.